With traditional bank lending, one of the credit risk red flags was always a lack of borrower diversity. How could a company risk having all its eggs in one basket? The extra pain extracted from highly correlated bank portfolios (i.e. both with real estate and geographic concentrations) in this crisis has brought that proverbial chicken home to roost in our own industry. Conceptually, we all now understand this; how do we practically affect this change?
Here’s a possible five-step plan for your bank to consider:
Step One: Adopt strategic plans that include alternative loan products, such as those tied to C&I (commercial & industrial) lending, or indirect / dealer automobile lending or even mortgage warehousing. Small Business Administration loans are another possibility. Recruit the talent that can implement these strategies for you.
Step Two: Disabuse yourselves of the following anti-C&I biases:
- It’s become just a consumerized product. This is a byproduct of the underwriting laziness adopted by many, where a small business owner’s credit score was the primary driver for this loan product.
- It’s tantamount to unsecured lending. Because it tends to focus on the top of the balance sheet, assets for collateral, lines of credit can be monitored effectively by procedures that use collateral such as stepped borrowing base agreements.
- It's asset-based lending. We're not talking about factoring-like products (buying or funding a customer's accounts receivable at a discount) that proliferated the '90's. They often failed because they were unwisely sold to banks as having primarily operational rather than credit risks at their heart.
Step Three: Ditch (or at least modify) the hunter-skinner delivery system for your bank’s loan officers. It doesn’t work. Some of the so-called efficiencies gained lend themselves better to the book and forget mindset that too often characterized our industry’s fixation on commercial real estate. This strategy also robs us of broad-based credit talent needed to fulfill the axiom: the market place rewards value-added.
Step Four: Train and re-train lenders and related lending staff (analysts, underwriters, credit officers) in the ways of cash flow and cash cycle analyses. Twenty years ago, most commercial bankers were experts in these classical credit tenets—and frankly treated real estate as a form of specialty lending. Over the past decade, commercial banks have been copying mortgage lending, abdicating too much of their core underwriting to third parties such as appraisers and credit rating agencies. The fundamentals of classic credit underwriting are not that intimidating—and like riding a bike, can come back to even the most dedicated commercial real estate devotees.
Step Five: Create the infrastructure needed to deliver and oversee this diversity investment. In addition to front-end underwriting, enhance:
- Use of practical loan covenants and borrowing base certificates to justify lines of credit;
- Portfolio servicing (post-booking checks of a borrower’s risk trends);
- Probative risk management tools (looking at future risks);
- Staff. Remember, the cost of one or two additional full-time equivalents pales in comparison to the bloodletting the industry has experienced, due in some part to bare-boned risk management infrastructures.
Lest one think these initiatives are designed to address only the risk component of lending, I would offer that they also help return the community banker back to the successful production role of lending to a diverse borrowing base: a win-win.
*Another version of this article was previously published in Carolina Banker in 2009.